Everyone understands that getting a 2009 Mercedes Benz S-class for the price of a 1964 Dodge Dart is a phenomenal value. But how does that translate into stock market investing? As of today, the S&P 500 has fallen to its lowest level since April 1997, so we clearly have Dodge pricing. But what value do we get in return? Are we getting the stock market equivalent of a Mercedes or are we getting a Dodge?
What exactly are we buying when we buy stocks? We are buying the stream of profits that those companies earn, which is measured in earnings per share (EPS). Since earnings per share increase over time, we likewise expect the price per share to rise.
In the table below, I compare the aggregate earnings per share of the S&P 500 today vs April 15, 1997. Benjamin Graham, the father of stock market investing (and Warren Buffett's mentor), taught that when evaluating the earnings of stocks, you must look at several years worth of earnings history to get a more accurate picture of the earning power of that company. For this exercise, I use the average of the previous three years earnings.
So is the stock market today giving us a silky-smooth, German-engineered machine, or a rusty bucket of bolts? Well, for the same price of the stock market in April 1997, we're getting about double the earnings power - $80.15 vs. $40.21 per share. From a value perspective, we're getting twice as much value today for our money.
The P/E ratio is simply the price per share of the stock market (measured by the S&P 500 index) divided by its earnings per share. Usually, this ratio rises when investors are confident and falls when investors are nervous. Currently, we have other factors at work in the financial markets which are driving stock prices down further, regardless of how good a value they are. What's driving this illogical behavior? Today's Wall Street Journal includes an excellent opinion article explaining five forces driving share prices lower. I highly encourage you to read it -- it's quick and easy to understand. Click here to read the article => WALL STREET JOURNAL
The portion of your portfolio that you may need to withdraw within five years should be invested in fixed income. Beyond your needs within five years, selling stock today is like walking away from a Mercedes Benz at a bargain basement pricing.